When it is not a rainy day

Not infrequently I come across someone who tells me that
he or she has invested or intends to invest in a life insurance policy. This
happens probably most of the time under the influence of an ‘insurance agent’.
But it can spell disaster for the investor.

Therefore it is better if we beware of the common
tendency of mistaking life insurance for investment. Let us be very clear that
insurance and investment are not one, each has its distinct purpose. The
purpose of life insurance is to provide financial protection to the dependents
of a bread earner of the family if the latter dies or falls seriously ill. An
insurance policy is meant to create an alternative source of financial support
for the family in case of such an eventuality. Investment is for preserving and
growing your savings so that your future may be better than the present.

You may feel that this is just a theoretical difference;
if the investment in life insurance can also grow, like any other investment,
then why not use a insurance policy as an investment plan? Your basic argument
may be right. But the hitch is in the detail. At least as of now, in India the
insurance corpus (the amount collected from policy holders as premium) is
managed by the insurers themselves. The core competency of an insurer is risk
management – making available a risk cover to the policy holder at the lowest
cost. It is not asset management, viz. earning maximum risk adjusted returns
for the investor.

Do not be confused by the risk. In both the cases they
are totally different risks. The risk in life insurance is pure risk, the risk
of death and illness while, the risk in investment is a bundle of default risk
and market risk.

Before I proceed any further, let me clarify the heading
of this article; because it looks just the opposite of what I am trying to say.
When we talk of a bad situation or an adverse event in insurance language, we normally
refer to a rainy day. It so happened that when I was writing this towards the
end of June the rain was just evading to come in full force in spite of all MET
department predictions. Every day I got up, I would look out of the window and
feel disappointed. Therefore the adverse event of ‘no rain.’

To understand the relation of investment and life
insurance, perhaps it will help to delve deeper into the portfolio of life
insurance products. The most basic of these is what is called the term insurance
which is pure insurance. You buy a term insurance policy and if you die your
nominee gets a lump sum. If you do not die nobody gets anything. Very much like
your vehicle insurance. You do not meet with an accident, nothing happens to
your vehicle you get nothing.

Your risk premium has been used to pay someone else whose
vehicle has met with an accident. That is the meaning of pure insurance. That
is what term insurance is. You will agree this can never have anything to do
with investment.

But there does exist an insurance product which mimics
investment. It is called an Endowment Policy (EP) which is actually a bundle of
some insurance and some investment. The premium for an EP is much higher than
that for term policy. The excess premium collected for an EP is invested. On
maturity the accumulated value of this investment is paid to the policy holder.
EP comes in two versions: traditional and ULIP. In case of the traditional EP,
the policy holder is not told how her premium is divided between risk premium
and investment.

In case of ULIP this split is made up front; the
policyholder knows even before buying the policy how much she will be paying as
the risk premium and how much will go into investment.

Traditional EP therefore is very opaque. It offers the
insurer an ample opportunity for manipulation and is therefore the worst
investment. ULIP is transparent; you know how much you are paying as the risk
premium to protect your dependents against financial distress in the
eventuality of your death and how much you are investing. It goes one step
further to let you choose where your investment part of the premium is
invested. Going still further, like the MFs it keeps you posted about how your
investment is faring as your dependents enjoy the protection.

But even the ULIP-EP is a bad investment. Next time let
us see why. And let us see the special situation when it becomes the desirable
product.

*The author is an investment consultant. Readers can send
their comments and queries to investment.ideas.shop@gmail.com